Are More Share Buybacks a Good Sign?

Share buybacks—companies using cash to buy stock in their own company—are becoming a more common way for American corporations to spend their money. In the first quarter of 2014 share buybacks from the largest US companies increased by 50% relative to the first quarter of last year, according to analysts at FactSet. Is such an increase a good sign or a bad sign for investors? The answer (perhaps unsurprisingly) is “it depends”.

First the positive aspects of share buybacks. They indicate that companies are confident about their future prospects, since otherwise they presumably wouldn’t be spending money to buy their own stock. They also are a way, like paying dividends, of returning cash to shareholders (when a company buys back its stock it reduces the total number of shares outstanding, increasing the remaining investors’ stakes in the company). Returning cash to shareholders is therefore a bullish sign for those who believe that companies would otherwise squander their excess cash by failing to invest it profitably. And share buybacks are more tax-friendly than dividends, since they don’t count as income for investors.

For each of these positives aspects, though, there is a negative side. Making substantial share buybacks may indicate a short-term focus on boosting earnings per share rather than trying to grow a business over the longer term. It can also increase vulnerability to an economic downturn: many companies that had repurchased shares in the mid-2000’s found themselves without enough spare cash when the financial crisis struck in 2008. And studies have shown that companies tend to destroy value for their investors by repurchasing shares when stock prices are high.

The bottom line: each company’s decision may be good or bad depending on why it’s doing the buyback and how good it is at predicting the future. Share buybacks can’t be universally categorized as “good” or “bad” for investors.